Divorce & Capital Gains on Real Property

Property values have skyrocketed over 19% annually, which is great news for homeowners – but leave it to Uncle Sam to be the fly in the ointment!

First and foremost, disclaimer:  We are not accountants and this shall not be construed as tax advice.

This article was sparked by a recent case where the wife was blindsided by capital gains. She faced a $62,000 hit when she agreed to take the couple’s rental property in the divorce – a condo they’d bought when they were first married.

In the divorce, husband kept the big house and wife got the condo. She planned on selling it to use the equity for a new place closer to the kids’ school. When she went to sell it, she was hit with the reality that she was solely on the hook for the capital gain, which came as a rude surprise.

Here are a few refreshers of what you probably already know. Since we are seeing this becoming a growing issue, We wanted to make them top of mind for you and for your clients.

 Capital Gains

The run-up of home values has increased the probability of your clients’ exposure to capital gains in a few ways:

1. Married filing jointly, the $500,000 exclusion may well be surpassed since values have risen so much. Depending on when they purchased it and for how much, the capital gain above the $500,000 threshold should be considered when determining settlement.
2. Should one be awarded the property and then sell later, their exclusion could be slashed in half to $250,000, and that could mean a huge hit that could have either been avoided altogether or mitigated substantially if sold while they could have taken the half-million dollar exclusion. Of course, the residency requirement (lived in the property for 24 months out of the last 5 years) is a factor, and that can get tricky depending on who claimed it as their primary residence and how long they’ve lived there recently.
3. Rental or non-owner occupied properties, if not 1031 exchanged, are likely going to be hit with capital gains which may include recapture of depreciation as well. Keep this in mind when your clients are negotiating on who keeps which property, and insist they speak with a tax professional (or at least have them acknowledge you urged them to if they don’t follow your advice)!
4. 1031 Exchanges have very specific rules and guidelines that must be followed during the listing of the property. They are especially complex in a divorce situation, and the parties must do their homework before putting the property on the market. I suggest they enlist the services of a 1031 exchange company early on. 

Friendly reminder, 1031 exchanges are not for primary residences. Only investment and business property can qualify. Here is the IRS’s fact sheet that you can refer your clients to: IRC Section 1031 Fact Sheet

Another good resource is the IRS’s publication titled Selling Your Home, and there are some specific sections that discuss when capital gains is incident to divorce: IRS Publication 523.

If you have a client whose primary residence’s value has increased significantly from when they bought it, you may want to direct them to check out IRS Publication 523, and most importantly, urge them to speak with a tax professional regarding this specific issue.

Lastly, should you have any questions about the real property matters in your case, please give us a call anytime. Get our contact info here. 

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